What is an Asset Allocation

Everyone who has ever thought of investing money in something might have thought about what to invest in. This is not an easy topic, as there are lots of possibilities. Having a target asset allocation is key. In this article, I will go into what an asset allocation is and how you can come up with one yourself.

Asset Types

In accounting, assets are things you own that have value. They are belongings you can liquidate, to turn them into cash. In other words, assets have a monetary value.

Assets are the opposite of liabilities, things that cost money to operate, or debt for example.

When you want to reach financial independence, you have to build up enough assets to have a solid financial situation. Having a large stack of assets means you maybe don’t have to work for money, because your (financial) assets are creating income for you.

There are many different types of assets you can invest in. Classic examples are stocks, bonds, and real estate. However, also things like crowdlending, cryptocurrencies, private loans, and private equity can considered asset types for financial independence.

Stocks

Stocks are tiny fractions of the ownership of a company. By investing in stocks, or buying shares, you buy a piece of ownership in an enterprise from another owner who’s decided to sell his stake.

By owning a piece of a business, you are entitled to all the good and the bad that happens with this company. It means you can participate in potential future profits, but also risk the loss of capital when the business is doing badly.

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Bonds

Where stocks are pieces of equity or ownership of a business, bonds are not. They basically are loans given out to a company or government by investors. The idea is simple: a company or government needs money. They sell some bonds to investors, which means that these investors loan money to the organisation. In return, the organisation promises to pay interest and the full amount back after the bond expires.

Investing in bonds is considered safer than investing in stocks. The reason is you don’t risk capital in the business, you loan money to a business. Of course, there are risks when investing in bonds. The company might fail to pay you back. The interest rates in the market might increase fast, meaning your bond is now worth less than what you bought it for.

Bonds can be traded with other investments, so they are generally pretty liquid.

Real Estate

Real estate is an obvious asset class to consider when talking about asset allocations. Real estate can be worth a lot of money, it can increase in value (also decrease of course), plus it can bring in regular income in the form of rent!

Especially the last one makes real estate an asset class lots of investors want to invest in.

How to Choose an Asset Allocation

Choosing an asset allocation for your own investing can be difficult. How much of my investments will go into stocks and bonds, and will I include real estate or any of the alternative investments?

A lot of people won’t consider real estate, since investing in real estate can be a lot of work, with a lot of risks involved.

So what most people choose is mix of stocks and bonds. The reason this is the default investment style for most people in the pursuit of financial freedom, is also that it’s incredibly easy these days to invest in stocks and bonds through low-cost, well-diversified index funds.

So how do you choose an asset allocation? For me it was easy; I am attracted to real estate, so I want 50% of my invested capital in real estate. The other 50% I would like in a mix of stocks and bonds. With other asset classes such as crowdlending I’m not that convinced they are the right fit for me.

Full disclaimer: I do have some money invested through crowdlending, and I also own a fair bit of cryptocurrencies. It’s just that I don’t consider these to be my long-term investments.

For me, I want my stock and bond investments to be determined by investing my age – 10 as the percentage bonds. So currently at age 26, that would be 84/16 split between stocks and bonds. Although currently, I don’t invest in bonds (since I hold a lot of cash) this is the strategy I will keep using going forward.

Default Stocks and Bonds Asset Allocation

This default stocks and bonds asset allocation can be something like 70/30 or 80/20 in stocks and bonds. You can also make it more dynamic, looking to invest aggressively when you’re young and more conservative when you get older.

You might want to implement a de-risking strategy like that by keeping your age as the percentage of bonds. So if you’re 20, only 20% of your investments is in bonds, 80% is in stocks.

I opt for a more aggressive asset allocation of my age minus 10 in bonds. So at age 20, I would invest only 10% in bonds.

Please mind that these are just default allocations. Always do your own research, I’m not here to advise, only to share my own thoughts and progress.

Mixing in Real Estate or Alternative Asset Types

If you want to mix in other assets such as real estate or some of the more exotic investments discussed earlier, you have to decide how to do this.

As I mentioned before, for me this additional asset type would be real estate. At the moment, I don’t have any real estate investments, but I am actively looking to purchase a rental in the near future.

For me currently, the ideal asset allocation will be 50% in real estate, and 50% in stocks and bonds. For the latter, I will then use the age minus 10 rule for as I’ve explained. Now of course, in the future things might change.

This proposed asset allocation currently gives me a 50/42/8 allocation between real estate, stocks, and bonds, which is pretty aggressive. Going forward I might gradually decrease the exposure to the more volatile investments by going for a 35/35/30 allocation for example.

What About Your Asset Allocation?

Did you think about this at all? Do you already invest, and if so, what is your asset allocation? Please let me know in the comments below.

First of all, I’m not in a position to give financial advice so take my opinion here with a grain of salt. Second, I would look at how long I have before I can retire (early or not). I think doing the average (or something close, it doesn’t really matter in the details anyway) is fine for starters. Then I would start to correct for the time left before I can retire. The longer the horizon is, the more aggressive you can invest. The money you need tomorrow is better kept in cash. The money you need 50 years from now can be invested 100% in stocks. But again, do your own research and make your own choice. This is not advice, rather an uneducated opinion.

Disclaimer

I’m not a financial advisor, nor am I an expert in anything I write on this site. I’m merely an enthusiastic individual documenting his road to financial independence.

I might write about investments I make, or other (financial) choices. These are intended only to document the way I look at things.

You always have to do your own research, and by no means can I ever been held liable for any damage or loss you suffered because of things you’ve read here. Always make you own decisions or consult a proper financial adviser!

I hope you enjoy the read, and that your path to financial independence goes well!